Abstract:

• Italy is being shaken by a major political crisis, significantly increasing the volatility of financial markets in the eurozone.
• An Italian sovereign crisis would be devastating for the country, but there is little chance of it spreading to peripheral countries in a dangerous way;
• In any case, the Italian crisis is not as severe as that of 2011-2012, and macroeconomic fundamentals are solid.

This article analyzes Italy’s macroeconomic situation as it faces a major political crisis. It examines the risks of a sovereign crisis, exit from the euro, central bank intervention, and contagion to the rest of the eurozone.

For the past two weeks, the markets have been particularly turbulent due to the political situation in Italy. Indeed, there is great confusion surrounding the political outcome of the government on the peninsula. A new election in Italy remains a likely scenario in the second half of 2018. The coming weeks are likely to be marked by high volatility, with significant intraday spreads on Italian 10-year bonds and a risk of contagion to other European assets.

Against this backdrop, Italian yields have risen sharply: the 10-year sovereign yield is up 125 bp to 3% and, in a particularly worrying sign, the yield curve has flattened significantly (+200 bp on the 2-year sovereign yield). The Italian equity market is also under pressure, falling 10% and wiping out all its gains for the year. At the same time, German 10-year debt played its role as a safe haven, falling more than 30 bp.

These changes mark the partial return of concerns about the stability of the eurozone.

1) Are we heading for a new sovereign crisis? Perhaps.

1.1. How big would the sovereign crisis be?

A sovereign crisis affecting the eurozone’s third-largest economy could be devastating for the country, for two main reasons:

• None of the stabilization instruments developed by the eurozone could be deployed in favor of Italy: if its rating were downgraded by two notches (currently BBB, one notch above the investment grade threshold) by at least one rating agency, Italy would no longer be eligible for quantitative easing (QE) by the central bank (countries classified as « non-investment grade » or « speculative, » i.e., BB+, are not eligible for QE by the central bank), which would refuse to accept Italian bonds as collateral. In addition, access to support mechanisms (via the European Stability Mechanism or the ECB’s Outright Monetary Transactions program) would be conditional on a consolidation program, which would contradict the current coalition’s program. Italy would then face a serious political crisis and could take the path of leaving the eurozone.
• Italy’s place in the eurozone economy: the crisis would be unprecedented for the country, with a collapse in credit, investment and market confidence, the redenomination of assets and a trade shock. The crisis could affect the entire eurozone through contagion effects, despite the ECB’s intervention in peripheral countries. In the event of an Italexit, the risk of the eurozone breaking up would reach a record high.

1.2. The coalition’s budget program contains all the ingredients for a debt crisis

The coalition’s economic program is based on an expansionary fiscal policy: introduction of a minimum income (M5S election program), flat tax (Lega), repeal of the pension reform (coalition agreement), and elimination of the automatic VAT increase (coalition agreement). All of these measures would cost between €110 billion and €150 billion (between 6% and 7% of Italian GDP). However, the coalition has denied that its program includes a request to cancel €250 billion of Italy’s debt and leave the eurozone.

The resulting increase in the deficit and the shift in the debt trajectory towards an unsustainable dynamic would be in breach of the requirements of the European Union and the financial markets.

The government would then be tempted to use what are known as « mini BOTs » (mini-treasury bills, Buoni Ordinario del Tesoro), debt acknowledgments issued by the state to settle its arrears with its creditors and suppliers. This would increase Italy’s debt, as a risk premium would necessarily be applied to these products. It would also send a signal to the markets that a national currency was being reintroduced within the monetary union.

1.3. Some safeguards before the sovereign crisis escalates

The scenario in which Italy loses access to financial markets (triggered by a downgrade of its credit rating and an explosion in the spread), fails to negotiate an adjustment program with the European authorities, and leaves the eurozone remains possible. However, it is unlikely that this will happen:

• The government may falter: the crisis will hit the Italian financial system and its banks, which are heavily exposed to Italian bonds, hard. Two-thirds of Italian debt is currently held by residents, which would make a sovereign debt crisis (and a fortiori a default) even more painful for the country. An Italian default would have a massive impact on Italians themselves and could lead to a political reversal.
• The majority in Parliament is weak: the measures in the coalition’s expansionary budget program, whose implementation would contribute to the crisis, will not be voted on until fall 2018 or even 2019. However, the majority in the Senate is tenuous (six votes), and an increase in the cost of credit caused by an irresponsible budget could potentially overturn the majority.
• Article 81 of the Constitution provides for a principle of budgetary balance and debt sustainability: if the budget becomes unconstitutional, the President of the Republic could then reject it.

Several scenarios are therefore possible: rising interest rates, massive outflows of investment, and possible sanctions from the European authorities. The government could also be forced to delay its budgetary measures. A European catastrophe can be avoided, but the costs (political, social, and economic) could nevertheless be high.

2. A financial crisis and contagion in the eurozone? Not necessarily.

The prospect of a coalition has significantly increased trading volume on financial markets, with investors incorporating this information into asset prices, particularly Italian bonds. The massive sale of Italian bonds increases the risk of debt unsustainability and contagion in the eurozone, but there seems to be no cause for panic.

First, it is unlikely that such a coalition will be able to implement the promised fiscal reforms. This should reassure investors in the short term. Second, it is normal for highly procyclical financial markets to react to fiscal policy proposals that are unsustainable in the medium term. Nevertheless, the lack of follow-through on these proposals is helping markets return to normal.

Chart 1 – Spreads on 10-year sovereign bond yields relative to Germany

Sources: Bloomberg, BSI Economics

The chart above highlights three points:

1. The Italian spread (300 bp on May 29 at 11 a.m.) has not yet reached the 2012 record (680 bp), even though it has been rising rapidly in recent days.
2. While the increase in Italian spreads is also affecting Portugal and Spain, the increase remains moderate. It is therefore not certain that a continued rise will create a massive shock and a sudden economic crisis in the Iberian Peninsula: if this is the case, the potential for contagion will justify massive intervention by the ECB in these regions. It should be noted, however, that Spain is currently in a politically unstable situation due to the PSOE’s motion of no confidence against the government and the dismissal of Mr. Rajoy on Friday, June¹.
3. The case of Portugal in early 2016 suggests that we should not be alarmed about Italy: with debt at 130% of GDP, a socialist government that has reversed some of the measures implemented during its adjustment program, weak growth at the time, and spreads at 400 bp for over a year, the country has regained investor confidence. It will take more time and much higher spreads to jeopardize the sustainability of Italian debt, especially since the Italian coalition is starting its term with primary and current surpluses.

However, there is no doubt that the uncertainty in Italy is dampening the prospects for institutional reform in the eurozone and will reduce European growth in 2018.

3. A crisis of confidence on the scale of 2011-2012? No.

While market volatility reflects investors’ fears and uncertainties about future Italian policies, there are solid reasons to believe that debt will remain sustainable and that Italy is not at risk of reliving the 2011-2012 crisis of confidence:

• Italy’s fundamentals have improved significantly: the budget deficit reached only 2.3% in 2017 (forecast at 1.7% in 2018); the country now has a primary surplus (1.5% of GDP in 2017). Growth reached 1.4% year-on-year in the first quarter of 2018, supported by European growth;

Chart 2 – Italian budget balance and external position

Sources: Bloomberg, BSI Economics

• Foreign investors hold less debt: the structure of the debt market has changed since 2011-2012, with foreign investors now holding only 32% of Italian debt (compared to 41% in 2010), of which investors outside the eurozone hold only 5%. The market is therefore less subject to volatile foreign flows of « hot money »;
• Debt servicing costs have fallen significantly: what matters in terms of debt sustainability is the cost of servicing, which currently stands at 2.8% (Chart 3), its lowest level since the introduction of the euro;
• Short-term refinancing risks have been eliminated: markets will certainly remain highly volatile in the short term, but the country will be able to repay its maturing coupons (currently averaging seven years).

Chart 3 – Cost of servicing Italian debt

Sources: Bloomberg, BSI Economics

Conclusion

In conclusion, the markets will be partly driven by Italian domestic politics, the formation of a potential government, and the potential election campaign ahead, thus maintaining a high level of volatility that is not conducive to taking decisive positions. Despite the populist promises of the new coalition, Italy’s macroeconomic outlook remains solid; it will certainly deteriorate in the coming months, but without jeopardizing the sustainability of Italian debt.